Investment income that would otherwise be excluded from an exempt
organization's unrelated business taxable income (see Exclusions
under Income earlier) must be included to the extent it is
derived from debt-financed property. The amount of income included is
proportionate to the debt on the property.
In general, the term "debt-financed property" means any
property held to produce income (including gain from its disposition)
for which there is an acquisition indebtedness at any time
during the tax year (or during the 12-month period before the date of
the property's disposal, if it was disposed of during the tax year).
It includes rental real estate, tangible personal property, and
For any debt-financed property, acquisition indebtedness is the
unpaid amount of debt incurred by an organization:
- When acquiring or improving the property,
- Before acquiring or improving the property if the debt would
not have been incurred except for the acquisition or improvement,
- After acquiring or improving the property if:
- The debt would not have been incurred except for the
acquisition or improvement, and
- Incurring the debt was reasonably foreseeable when the
property was acquired or improved.
The facts and circumstances of each situation determine whether
incurring a debt was reasonably foreseeable. That an organization may
not have foreseen the need to incur a debt before acquiring or
improving the property does not necessarily mean that incurring the
debt later was not reasonably foreseeable.
Y, an exempt scientific organization, mortgages its laboratory to
replace working capital used in remodeling an office building that Y
rents to an insurance company for nonexempt purposes. The debt is
acquisition indebtedness since the debt, though incurred after the
improvement of the office building, would not have been incurred
without the improvement, and the debt was reasonably foreseeable when,
to make the improvement, Y reduced its working capital below the
amount necessary to continue current operations.
X, an exempt organization, forms a partnership with A and B. The
partnership agreement provides that all three partners will share
equally in the profits of the partnership, each will invest $3
million, and X will be a limited partner. X invests $1 million of its
own funds in the partnership and $2 million of borrowed funds.
The partnership buys as its sole asset an office building that it
leases to the public for nonexempt purposes. The office building costs
the partnership $24 million, of which $15 million is borrowed from Y
bank. The loan is secured by a mortgage on the entire office building.
By agreement with Y bank, X is not personally liable for payment of
X has acquisition indebtedness of $7 million. This amount is the
$2 million debt X incurred in acquiring the partnership interest, plus
the $5 million that is X's allocable part of the partnership's debt
incurred to buy the office building (one-third of $15 million).
A labor union advanced funds, from existing resources and without
any borrowing, to its tax-exempt subsidiary title-holding company. The
subsidiary used the funds to pay a debt owed to a third party that was
previously incurred in acquiring two income-producing office
buildings. Neither the union nor the subsidiary has incurred any
further debt in acquiring or improving the property. The union has no
outstanding debt on the property. The subsidiary's debt to the union
is represented by a demand note on which the subsidiary makes payments
whenever it has the available cash. The books of the union and the
subsidiary list the outstanding debt as interorganizational
Although the subsidiary's books show a debt to the union, it is not
the type subject to the debt-financed property rules. In this
situation, the very nature of the title-holding company and the
parent-subsidiary relationship shows this debt to be merely a matter
of accounting between the two organizations. Accordingly, the debt is
not acquisition indebtedness.
Change in use of property.
If an organization converts property that is not debt-financed
property to a use that results in its treatment as debt-financed
property, the outstanding principal debt on the property is thereafter
treated as acquisition indebtedness.
Four years ago a university borrowed funds to acquire an apartment
building as housing for married students. Last year, the university
rented the apartment building to the public for nonexempt purposes.
The outstanding principal debt becomes acquisition indebtedness as of
the time the building was first rented to the public.
If an organization sells property and, without paying off debt that
would be acquisition indebtedness if the property were debt-financed
property, buys property that is otherwise debt-financed property, the
unpaid debt is acquisition indebtedness for the new property. This is
true even if the original property was not debt-financed property.
To house its administration offices, an exempt organization bought
a building using $600,000 of its own funds and $400,000 of borrowed
funds secured by a pledge of its securities. The office building was
not debt-financed property. The organization later sold the building
for $1 million without repaying the $400,000 loan. It used the sale
proceeds to buy an apartment building it rents to the general public.
The unpaid debt of $400,000 is acquisition indebtedness with respect
to the apartment building.
Property acquired subject to mortgage or lien.
If property (other than certain gifts, bequests, and devises) is
acquired subject to a mortgage, the outstanding principal debt secured
by that mortgage is treated as acquisition indebtedness even if the
organization did not assume or agree to pay the debt.
An exempt organization paid $50,000 for real property valued at
$150,000 and subject to a $100,000 mortgage. The $100,000 of
outstanding principal debt is acquisition indebtedness, as though the
organization had borrowed $100,000 to buy the property.
Liens similar to a mortgage.
In determining acquisition indebtedness, a lien similar to a
mortgage is treated as a mortgage. A lien is similar to a mortgage if
title to property is encumbered by the lien for a creditor's benefit.
However, when state law provides that a lien for taxes or
assessments attaches to property before the taxes or assessments
become due and payable, the lien is not treated as a mortgage until
after the taxes or assessments have become due and payable and the
organization has had an opportunity to pay the lien in accordance with
state law. Liens similar to mortgages include (but are not limited
- Deeds of trust,
- Conditional sales contracts,
- Chattel mortgages,
- Security interests under the Uniform Commercial Code,
- Agreements to hold title in escrow, and
- Liens for taxes or assessments (other than those discussed
earlier in this paragraph).
Exception for property acquired by gift, bequest, or devise.
If property subject to a mortgage is acquired by gift, bequest, or
devise, the outstanding principal debt secured by the mortgage is not
treated as acquisition indebtedness during the 10-year period
following the date the organization receives the property. However,
this applies to a gift of property only if:
- The mortgage was placed on the property more than 5 years
before the date the organization received it, and
- The donor held the property for more than 5 years before the
date the organization received it.
This exception does not apply if an organization assumes and agrees
to pay all or part of the debt secured by the mortgage or makes any
payment for the equity in the property owned by the donor or decedent
(other than a payment under an annuity obligation excluded from the
definition of acquisition indebtedness, discussed later under
Debt That Is Not Acquisition Indebtedness).
Whether an organization has assumed and agreed to pay all or part
of a debt in order to acquire the property is determined by the facts
and circumstances of each situation.
Modifying existing debt.
Extending, renewing, or refinancing an existing debt is considered
a continuation of that debt to the extent its outstanding principal
does not increase. When the principal of the modified debt is more
than the outstanding principal of the old debt, the excess is treated
as a separate debt.
Extension or renewal.
In general, any modification or substitution of the terms of a debt
by an organization is considered an extension or renewal of the
original debt, rather than the start of a new one, to the extent that
the outstanding principal of the debt does not increase.
The following are examples of acts resulting in the extension or
renewal of a debt:
- Substituting liens to secure the debt,
- Substituting obligees whether or not with the organization's
- Renewing, extending, or accelerating the payment terms of
the debt, and
- Adding, deleting, or substituting sureties or other primary
or secondary obligors.
If the outstanding principal of a modified debt is more than that
of the unmodified debt, and only part of the refinanced debt is
acquisition indebtedness, the payments on the refinanced debt must be
allocated between the old debt and the excess.
An organization has an outstanding principal debt of $500,000 that
is treated as acquisition indebtedness. The organization borrows
another $100,000, which is not acquisition indebtedness, from the same
lender, resulting in a $600,000 note for the total obligation. A
payment of $60,000 on the total obligation would reduce the
acquisition indebtedness by $50,000 ($60,000 X $500,000/$600,000)
and the excess debt by $10,000.
Debt That Is Not Acquisition Indebtedness
Certain debt and obligations are not acquisition indebtedness.
These include the following.
- Debts incurred in performing an exempt purpose.
- Annuity obligations.
- Securities loans.
- Real property debts of qualified organizations.
- Certain Federal financing.
Debt incurred in performing exempt purpose.
A debt incurred in performing an exempt purpose is not acquisition
indebtedness. For example, acquisition indebtedness does not include
the debt an exempt credit union incurs in accepting deposits from its
members or the debt an exempt organization incurs in accepting
payments from its members to provide them with insurance, retirement,
or other benefits.
The organization's obligation to pay an annuity is not acquisition
indebtedness if the annuity meets all the following requirements.
- It must be the sole consideration (other than a mortgage on
property acquired by gift, bequest, or devise that meets the exception
discussed under Property acquired subject to mortgage or lien,
earlier in this chapter) issued in exchange for the property
- Its present value, at the time of exchange, must be less
than 90% of the value of the prior owner's equity in the property
- It must be payable over the lives of either one or two
individuals living when issued.
- It must be payable under a contract that:
- Does not guarantee a minimum nor specify a maximum number of
- Does not provide for any adjustment of the amount of the
annuity payments based on the income received from the transferred
property or any other property.
X, an exempt organization, receives property valued at $100,000
from donor A, a male age 60. In return X promises to pay A $6,000 a
year for the rest of A's life, with neither a minimum nor maximum
number of payments specified. The amounts paid under the annuity are
not dependent on the income derived from the property transferred to
X. The present value of this annuity is $81,156, determined from IRS
valuation tables. Since the value of the annuity is less than 90
percent of A's $100,000 equity in the property transferred and the
annuity meets all the other requirements just discussed, the
obligation to make annuity payments is not acquisition indebtedness.
Acquisition indebtedness does not include an obligation of the
exempt organization to return collateral security provided by the
borrower of the exempt organization's securities under a securities
loan agreement (discussed under Exclusions earlier in this
chapter). This transaction is not treated as the borrowing by the
exempt organization of the collateral furnished by the borrower
(usually a broker) of the securities.
However, if the exempt organization incurred debt to buy the loaned
securities, any income from the securities (including income from
lending the securities) would be debt-financed income. For this
purpose, any payments because of the securities are considered to be
from the securities loaned and not from collateral security or the
investment of collateral security from the loans. Any deductions that
are directly connected with collateral security for the loan, or with
the investment of collateral security, are considered deductions that
are directly connected with the securities loaned.
Acquisition indebtedness does not include the "borrowing" of
stock from a broker to sell the stock short. Although a short sale
creates an obligation, it does not create debt.
Real property debts of qualified organizations.
In general, acquisition indebtedness does not include debt incurred
by a qualified organization in acquiring or improving any real
property. A qualified organization is:
- A qualified retirement plan under section 401(a),
- An educational organization described in section
170(b)(1)(A)(ii) and certain of its affiliated support organizations,
- A title-holding company described in section
This exception from acquisition indebtedness does not apply
in the following six situations.
- The acquisition price is not a fixed amount determined as of
the date of the acquisition or the completion of the improvement.
However, the terms of a sales contract may provide for price
adjustments due to customary closing adjustments such as prorating
property taxes. The contract also may provide for a price adjustment
if it is for a fixed amount dependent upon subsequent resolution of
limited, external contingencies such as zoning approvals, title
clearances, and the removal of easements. These conditions in the
contract will not cause the price to be treated as an undetermined
amount. (But see Note 1 at the end of this list.)
- Any debt or other amount payable for the debt, or the time
for making any payment, depends, in whole or in part, upon any
revenue, income, or profits derived from the real property. (But see
Note 1 at the end of this list.)
- The real property is leased back to the seller of the
property or to a person related to the seller as described in section
267(b) or section 707(b). (But see Note 2 at the end of
- The real property is acquired by a qualified retirement plan
from, or after its acquisition is leased by a qualified retirement
plan to, a related person. (But see Note 2 at the end of
this list.) For this purpose, a related person is:
- An employer who has employees covered by the plan,
- An owner with at least a 50% interest in an employer
described in (a),
- A member of the family of any individual described in (a) or
- A corporation, partnership, trust, or estate in which a
person described in (a), (b), or (c) has at least a 50% interest,
- An officer, director, 10% or more shareholder, or highly
compensated employee of a person described in (a), (b), or (d).
- The seller, a person related to the seller (under section
267(b) or section 707(b)), or a person related to a qualified
retirement plan (as described in (4)) provides financing for the
transaction on other than commercially reasonable terms.
- The real property is held by a partnership in which an
exempt organization is a partner (along with taxable entities), and
the principal purpose of any allocation to an exempt organization is
to avoid tax. This generally applies to property placed in service
after 1986. For more information, see section 514(c)(9)(B)(vi) and
Qualifying sales by financial institutions of foreclosure property
or certain conservatorship or receivership property are not included
in (1) or (2) and, therefore, do not give rise to acquisition
indebtedness. For more information, see section 514(c)(9)(H).
For purposes of (3) and (4), small leases are disregarded. A small
lease is one that covers no more than 25% of the leasable floor space
in the property and has commercially reasonable terms.
Certain federal financing.
Acquisition indebtedness does not include an obligation, to the
extent it is insured by the Federal Housing Administration, to finance
the purchase, rehabilitation, or construction of housing for low or
moderate income people.
Exceptions to Debt-Financed Property
Certain property is excepted from treatment as debt-financed
Property related to exempt purposes.
If substantially all (85% or more) of the use of any property is
substantially related to an organization's exempt purposes, the
property is not treated as debt-financed property. Related use does
not include a use related solely to the organization's need for
income, or its use of the profits. The extent to which property is
used for a particular purpose is determined on the basis of all the
facts. They may include:
- A comparison of the time the property is used for exempt
purposes with the total time the property is used,
- A comparison of the part of the property that is used for
exempt purposes with the part used for all purposes, or
- Both of these comparisons.
If less than 85% of the use of any property is devoted to an
organization's exempt purposes, only that part of the property that is
used to further the organization's exempt purposes is not treated as
Property used in an unrelated trade or business.
To the extent that the gross income from any property is treated as
income from the conduct of an unrelated trade or business, the
property is not treated as debt-financed property. However, any gain
on the disposition of the property that is not included in income from
an unrelated trade or business is includible as gross income derived
from, or on account of, debt-financed property.
The rules for debt-financed property do not apply to rents from
personal property, certain passive income from controlled
organizations, and other amounts that are required by other rules to
be included in computing unrelated business taxable income.
Property used in research activities.
Property is not treated as debt-financed property when it produces
gross income derived from research activities otherwise excluded from
the unrelated trade or business tax. See Income from research
under Exclusions, earlier in this chapter.
Property used in certain excluded activities.
Debt-financed property does not include property used in a trade or
business that is excluded from the definition of "unrelated trade or
- It has a volunteer workforce,
- It is carried on for the convenience of its members,
- It consists of selling donated merchandise.
See Excluded Trade or Business Activities in chapter 3.
Related exempt uses.
Property owned by an exempt organization and used by a related
exempt organization, or by an exempt organization related to that
related exempt organization, is not treated as debt-financed property
when the property is used by either organization to further its exempt
purpose. Furthermore, property is not treated as debt-financed
property when a related exempt organization uses it for research
activities or certain excluded activities, as described above.
An exempt organization is related to another exempt organization
- One organization is an exempt holding company and the other
receives profits derived by the exempt holding company,
- One organization controls the other as discussed under
Income From Controlled Organizations earlier in this
- More than 50% of the members of one organization are members
of the other, or
- Each organization is a local organization directly
affiliated with a common state, national, or international
organization that also is exempt.
Real property is not debt-financed property if it is leased to a
medical clinic and the lease is entered into primarily for purposes
related to the lessor's exercise or performance of its exempt purpose.
An exempt hospital leases all of its clinic space to an
unincorporated association of physicians and surgeons. They, under the
lease, agree to provide all of the hospital's outpatient medical and
surgical services and to train all of the hospital's residents and
interns. In this case the rents received are not unrelated
Life income contract.
If an individual transfers property to a trust or a fund with the
income payable to that individual or other individuals for a period
not to exceed the life of the individual or individuals, and with the
remainder payable to an exempt charitable organization, the property
is not treated as debt-financed property. This exception applies only
where the payments to the individual are not the proceeds of a sale or
exchange of the property transferred.
Neighborhood land rule.
If an organization acquires real property with the intention of
using the land for exempt purposes within 10 years, it will not be
treated as debt-financed property if it is in the neighborhood of
other property that the organization uses for exempt purposes. This
rule applies only if the intent to demolish any existing structures
and use the land for exempt purposes within 10 years is not abandoned.
Property is considered in the neighborhood of property
that an organization owns and uses for its exempt purposes if it is
contiguous with the exempt purpose property or would be contiguous
except for an intervening road, street, railroad, stream, or similar
property. If it is not contiguous with the exempt purpose property, it
still may be in the same neighborhood if it is within one mile of the
exempt purpose property and if the facts and circumstances make it
unreasonable to acquire the contiguous property.
Some issues to consider in determining whether acquiring contiguous
property is unreasonable include the availability of land and the
intended future use of the land.
A university tries to buy land contiguous to its present campus,
but cannot do so because the owners either refuse to sell or ask
unreasonable prices. The nearest land of sufficient size and utility
is a block away from the campus. The university buys this land. Under
these circumstances, the contiguity requirement is unreasonable and
not applicable. The land bought would be considered neighborhood land.
For all organizations other than churches and conventions or
associations of churches, discussed later under Churches,
the neighborhood land rule does not apply to property after the
10 years following its acquisition. Further, the rule applies after
the first 5 years only if the organization satisfies the IRS that use
of the land for exempt purposes is reasonably certain before the
10-year period expires. The organization need not show binding
contracts to satisfy this requirement; but it must have a definite
plan detailing a specific improvement and a completion date, and it
must show some affirmative action toward the fulfillment of the plan.
This information should be forwarded to the IRS for a ruling at least
90 days before the end of the 5th year after acquisition of the land.
Address it to:
Internal Revenue Service
P.O. Box 120, Ben Franklin Station
Washington, DC 20044
The IRS may grant a reasonable extension
of time for requesting the ruling if the organization can show good
cause. For more information, contact the IRS.
If the neighborhood land rule does not apply because the acquired
land is not in the neighborhood of other land used for an
organization's exempt purposes, or because the organization fails to
establish after the first 5 years of the 10-year period that the
property will be used for exempt purposes, but the land is used
eventually by the organization for its exempt purposes within the
10-year period, the property is not treated as debt-financed property
for any period before the conversion.
The neighborhood land rule or actual use rule applies to any
structure on the land when acquired, or to the land occupied by the
structure, only so long as the intended future use of the land in
furtherance of the organization's exempt purpose requires that the
structure be demolished or removed in order to use the land in this
manner. Thus, during the first 5 years after acquisition (and for
later years if there is a favorable ruling), improved property is not
debt financed so long as the organization does not abandon its intent
to demolish the existing structures and use the land in furtherance of
its exempt purpose. If an actual demolition of these structures
occurs, the use made of the land need not be the one originally
intended as long as its use furthers the organization's exempt
In addition to this limit, the neighborhood land rule and the
actual use rule do not apply to structures erected on land after its
acquisition. They do not apply to property subject to a business
lease (as defined in section 514 immediately before the
enactment of the Tax Reform Act of 1976) whether an organization
acquired the property subject to the lease, or whether it executed the
lease after acquisition. A business lease is any lease, with certain
exceptions, of real property for a term of more than 5 years by an
exempt organization if at the close of the lessor's tax year there is
a business lease (acquisition) indebtedness on that property.
Refund of taxes.
When the neighborhood land rule does not initially apply, but the
land is used eventually for exempt purposes, a refund or credit of any
overpaid taxes will be allowed for a prior tax year as a result of the
satisfaction of the actual use rule. A claim must be filed within one
year after the close of the tax year in which the actual use rule is
satisfied. Interest rates on any overpayment are governed by the
In January 1992, Y, a calendar year exempt organization, acquired
real property contiguous to other property that Y uses in furtherance
of its exempt purpose. Assume that without the neighborhood land rule,
the property would be debt-financed property. Y did not satisfy the
IRS by January 1997 that the existing structure would be demolished
and the land would be used in furtherance of its exempt purpose. From
1997 until the property is converted to an exempt use, the income from
the property is subject to the tax on unrelated business income.
During July 2001, Y will demolish the existing structure on the land
and begin using the land in furtherance of its exempt purpose. At that
time, Y can file claims for refund for the open years 1998 through
Further, Y also can file a claim for refund for 1997, even though a
claim for that tax year may be barred by the statute of limitations,
provided the claim is filed before the close of 2002.
The neighborhood land rule as described here also applies to
churches, or a convention or association of churches, but with two
- The period during which the organization must demonstrate
the intent to use acquired property for exempt purposes is increased
from 10 to 15 years, and
- Acquired property does not have to be in the neighborhood of
other property used by the organization for exempt purposes.
Thus, if a church or association or convention of churches acquires
real property for the primary purpose of using the land in the
exercise or performance of its exempt purpose, within 15 years after
the time of acquisition, the property is not treated as debt-financed
property as long as the organization does not abandon its intent to
use the land in this manner within the 15-year period.
This exception for a church or association or convention of
churches does not apply to any property after the 15-year period
expires. Further, this rule will apply after the first 5 years of the
15-year period only if the church or association or convention of
churches establishes to the satisfaction of the IRS that use of the
acquired land in furtherance of the organization's exempt purpose is
reasonably certain before the 15-year period expires.
If a church or association or convention of churches cannot
establish after the first 5 years of the 15-year period that use of
acquired land for its exempt purpose is reasonably certain within the
15-year period, but the land is in fact converted to an exempt use
within the 15-year period, the land is not treated as debt-financed
property for any period before the conversion.
The same rule for demolition or removal of structures as discussed
earlier in this chapter under Limits applies to a church or
an association or a convention of churches.
Computation of Debt-Financed Income
For each debt-financed property, the unrelated debt-financed income
is a percentage (not over 100%) of the total gross income derived
during a tax year from the property. This percentage is the same
percentage as the average acquisition indebtedness with respect to the
property for the tax year is of the property's average adjusted basis
for the year (the debt/basis percentage). Thus, the formula for
deriving unrelated debt-financed income is:
X, an exempt trade association, owns an office building that is
debt-financed property. The building produced $10,000 of gross rental
income last year. The average adjusted basis of the building during
that year was $100,000, and the average acquisition indebtedness with
respect to the building was $50,000. Accordingly, the debt/basis
percentage was 50% (the ratio of $50,000 to $100,000). Therefore, the
unrelated debt-financed income with respect to the building was $5,000
(50% of $10,000).
Gain or loss from sale or other disposition of property.
If an organization sells or otherwise disposes of debt-financed
property, it must include, in computing unrelated business taxable
income, a percentage (not over 100%) of any gain or loss. The
percentage is that of the highest acquisition indebtedness with
respect to the property during the 12-month period preceding the date
of disposition, in relation to the property's average adjusted basis.
The tax on this percentage of gain or loss is determined according
to the usual rules for capital gains and losses. These amounts may be
subject to the alternative minimum tax. (See Alternative minimum
tax at the beginning of chapter 2.)
Debt-financed property exchanged for subsidiary's stock.
A transfer of debt-financed property by a tax-exempt organization
to its wholly owned taxable subsidiary, in exchange for additional
stock in the subsidiary, is not considered a gain subject to the tax
on unrelated business income.
A tax-exempt hospital wants to build a new hospital complex to
replace its present old and obsolete facility. The most desirable
location for the new hospital complex is a site occupied by an
apartment complex. Several years ago the hospital bought the land and
apartment complex, taking title subject to a first mortgage already on
For valid business reasons, the hospital proposed to exchange the
land and apartment complex, subject to the mortgage on the property,
for additional stock in its wholly owned subsidiary. The exchange
satisfied all the requirements of section 351(a).
The transfer of appreciated debt-financed property from the
tax-exempt hospital to its wholly owned subsidiary in exchange for
stock did not result in a gain subject to the tax on unrelated
Average acquisition indebtedness.
This is the average amount of outstanding principal debt during the
part of the tax year that the organization holds the property.
Average acquisition indebtedness is computed by determining how
much principal debt is outstanding on the first day in each calendar
month during the tax year that the organization holds the property,
adding these amounts, and dividing the sum by the number of months
during the year that the organization held the property. Part of a
month is treated as a full month in computing average acquisition
If an organization acquires or improves property for an
indeterminate price (that is, neither the price nor the debt is
certain), the unadjusted basis and the initial acquisition
indebtedness are determined as follows, unless the organization
obtains the IRS's consent to use another method. The unadjusted basis
is the fair market value of the property or improvement on the date of
acquisition or completion of the improvement. The initial acquisition
indebtedness is the fair market value of the property or improvement
on the date of acquisition or completion of the improvement, less any
down payment or other initial payment applied to the principal debt.
Average adjusted basis.
The average adjusted basis of debt-financed property is the average
of the adjusted basis of the property as of the first day and as of
the last day that the organization holds the property during the tax
Determining the average adjusted basis of the debt-financed
property is not affected if the organization was exempt from tax for
prior tax years. The basis of the property must be adjusted properly
for the entire period after the property was acquired. As an example,
adjustment must be made for depreciation during all prior tax years
whether or not the organization was tax-exempt. If only part of the
depreciation allowance may be taken into account in computing the
percentage of deductions allowable for each debt-financed property,
that does not affect the amount of the depreciation adjustment to use
in determining average adjusted basis.
Basis for debt-financed property acquired in corporate
If an exempt organization acquires debt-financed property in a
complete or partial liquidation of a corporation in exchange for its
stock, the organization's basis in the property is the same as it
would be in the hands of the transferor corporation. This basis is
increased by the gain recognized to the transferor corporation upon
the distribution and by the amount of any gain that, because of the
distribution, is includible in the organization's gross income as
unrelated debt-financed income.
Computation of debt/basis percentage.
The following example shows how to compute the debt/basis
percentage by first determining the average acquisition indebtedness
and average adjusted basis.
On July 7, an exempt organization buys an office building for
$510,000 using $300,000 of borrowed funds. The organization files its
return on a calendar year basis. During the year the only adjustment
to basis is $20,000 for depreciation. Starting July 28, the
organization pays $20,000 each month on the mortgage principal plus
interest. The debt/basis percentage for the year is calculated as
|Debt on first day
of each month
||property is held
$1,500,000 x 6 months
|As of July 7
|As of December 31
|Average adjusted basis:
$1,000,000 x 2
Deductions for Debt-Financed Property
The deductions allowed for each debt-financed property are
determined by applying the debt/basis percentage to the sum of
The allowable deductions are those directly connected with the
debt-financed property or with the income from it (including the
dividends-received deduction), except that:
- The allowable deductions are subject to the modifications
for computation of the unrelated business taxable income (discussed
earlier in this chapter), and
- The depreciation deduction, if allowable, is computed only
by use of the straight-line method.
To be directly connected with debt-financed property or
with the income from it, a deductible item must have proximate and
primary relationship to the property or income. Expenses,
depreciation, and similar items attributable solely to the property
qualify for deduction, to the extent they meet the requirements of an
For example, if the straight-line depreciation allowance for an
office building is $10,000 a year, an organization can deduct
depreciation of $10,000 if the entire building is debt-financed
property. However, if only half of the building is debt-financed
property, the depreciation allowed as a deduction is $5,000.
If a sale or exchange of debt-financed property results in a
capital loss, the loss taken into account in the tax year in which the
loss arises is computed as provided earlier. See Gain or loss
from sale or other disposition of property under
Computation of Debt-Financed Income.
If any part of the allowable capital loss is not taken into account
in the current tax year, it may be carried back or carried over to
another tax year without application of the debt/basis percentage for
X, an exempt educational organization, owned debt-financed
securities that were capital assets. Last year, X sold the securities
at a loss of $20,000. The debt/basis percentage for computing the loss
from the sale of the securities is 40%. Thus, X sustained a capital
loss of $8,000 (40% of $20,000) on the sale of the securities. Last
year and the preceding 3 tax years, X had no other capital
transactions. Under these circumstances, the $8,000 of capital loss
may be carried over to succeeding years without further application of
the debt/basis percentage.
Net operating loss.
If, after applying the debt/basis percentage to the income from
debt-financed property and the deductions directly connected with this
income, the deductions exceed the income, an organization has a net
operating loss for the tax year. This amount may be carried back or
carried over to other tax years in the same manner as any other net
operating loss of an organization with unrelated business taxable
income. (For a discussion of the net operating loss deduction, see
Modifications under Deductions earlier in this
chapter.) However, the debt/basis percentage is not applied in those
other tax years to determine the deductions that may be taken in those
Last year, Y, an exempt organization, received $20,000 of rent from
a debt-financed building that it owns. Y had no other unrelated
business taxable income for the year. The deductions directly
connected with this building were property taxes of $5,000, interest
of $5,000 on the acquisition indebtedness, and salary of $15,000 to
the building manager. The debt/basis percentage with respect to the
building was 50%. Under these circumstances, Y must take into account,
in computing its unrelated business taxable income, $10,000 (50% of
$20,000) of income and $12,500 (50% of $25,000) of the deductions
directly connected with that income.
Thus, Y sustained a net operating loss of $2,500 ($10,000 of income
less $12,500 of deductions), which may be carried back or carried over
to other tax years without further application of the debt/basis
When only part of the property is debt-financed property, proper
allocation of the basis, debt, income, and deductions with respect to
the property must be made to determine how much income or gain derived
from the property to treat as unrelated debt-financed income.
X, an exempt college, owns a four-story office building that it
bought with borrowed funds (assumed to be acquisition indebtedness).
During the year, the lower two stories of the building were used to
house computers that X uses for administrative purposes. The two upper
stories were rented to the public and used for nonexempt purposes.
The gross income X derived from the building was $6,000, all of
which was attributable to the rents paid by tenants. The expenses were
$2,000 and were equally allocable to each use of the building. The
average adjusted basis of the building for the year was $100,000 and
the average acquisition indebtedness for the year was $60,000.
Since the two lower stories were used for exempt purposes, only the
upper half of the building is debt-financed property. Consequently,
only the rental income and the deductions directly connected with this
income are taken into account in computing unrelated business taxable
income. The part taken into account is determined by multiplying the
$6,000 of rental income and $1,000 of deductions directly connected
with the rental income by the debt/basis percentage.
The debt/basis percentage is the ratio of the allocable part of the
average acquisition indebtedness to the allocable part of the
property's average adjusted basis: that is, in this case, the ratio of
$30,000 (one-half of $60,000) to $50,000 (one-half of $100,000). Thus,
the debt/basis percentage for the year is 60% (the ratio of $30,000 to
Under these circumstances, X must include net rental income of
$3,000 in its unrelated business taxable income for the year, computed
|Rental income treated as gross income
from an unrelated trade or business (60% of $6,000)
|Less the allowable portion of
deductions directly connected with that income (60% of $1,000)
|Net rental income included by X in
computing its unrelated business taxable income from debt-financed
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